Which Banks Could Fail?

It's a debate we've been hammering away at on Money for Breakfast. I've got the names of banks you ought to take a look at, read through to the bottom.

First, don't be fooled by the growing chorus of critics making inapt comparisons between the current US crisis and the one that plunged Japan into its “lost decade” of a fitful string of recessions that left Japan in an invertebrate state.

Some coolants are needed—analysts need to think this through, the differences are many and important. When I hear these parallels, I'm mindful of the saying, “a conclusion is where the mind comes to rest.”

The debt crisis in Japan was largely due to a reluctance to admit mistakes and subsequent foot-dragging over writing off bad loans. Japan prolonged its crisis, which lasted from the late ‘80s through the early part of this century, because it let banks keep zombie loans on the books for far too long and covered them up with disclosures that were about as transparent as a bucket of molasses.

Japan then waited to clear bank balance sheets of some $400bn in zombie loans only until 1998 to 2004. And many banks in Japan bailed each other out by buying equity stakes in other creaky banks, so executives were loathe to quickly unload stakes or write off assets (honor among thieves). Japan, too, was agonizingly slow to cut rates, waiting to ease until 1999.

The U.S.'s debt crisis is largely due to self-regarding Wall Street geeks too clever by half who financially engineered opaque securities even they could not understand, whose bosses stayed too long at the fee-flowing subprime party through 2007, even though computer screens were flashing glaring red signs starting in 2005--artificial intelligence being no match for natural foolishness.

But what's different in the U.S. is that accounting rules are forcing much more rapid bank writedowns. Plus U.S. banks here do not have anywhere near the investments in each other as Japan's banks did. Also the Fed is cutting interest rates more quickly and widening the discount window, too. Fed chairman Buzzsaw Ben Bernanke is well aware of failed monetary policy in Japan, (having written a paper at Princeton, “Japanese Monetary Policy: A Case of Self-induced Paralysis?”).

So what to do about a free-market free-for-all abetted by a too-loose monetary policy that blew out a massive bubble? A bubble inflated by the metaphysical certitude that house prices can defy physics and reach to Mars?

Slashing rates won't stop a free-fall in asset prices, but they do help break up the ice in the credit markets. And a government bailout that still aids too much debt forgiveness for irresponsible borrowers and abets excess consumption is dangerously myopic.

A bailout that puts banks at risk of trying to keep alive zombie mortgages, where borrowers have handed the keys to the bankers and have scurried away, dead loan walking, is perilous as well.

Fiscal stimulus in the form of taxpayers getting their own money back as rebate checks can help keep the economy thrumming—so long as the US saves more.

Asset bubbles are fun on the way up, but the workouts are excruciating when they blow. As the pipes burst at bank after bank on Wall Street, TV screens are now jammed with rather orotund after-the-fact refereeing that should be on any right-thinking individual's ninth nerve (see Fed vice chair Donald Kohn telling the Senate he believes more regulation would have been better, a rare admission from a Fed official).

The downturn will last until housing finds its bottom. But given the guardrails are still few in number, a bubble could derail the markets and the economy again. So look for the lessons to learn by watching the banks now at risk.

Which banks could fail, or get bought out on weakness?

First, always watch out for fat cat pay when banks are at play, a corporate governance weakness I've noted to you in a prior blog (“The Richie Riches of the Housing Mess”). Banks that can't run their executive compensation properly likely can't administer their operations well, governance analysts have noted.

For instance, Washington Mutual (WM), whose shares are down 70% in the past 52 weeks due to the subprime and credit crisis, recently tied its executive cash bonuses to earnings results that do not take into account mortgage losses and foreclosures. Bonuses are supposed to give execs incentives to perform well--not de-incentivize them, as it were. And check out this disclosure in a recent annual report from Wamu.

Wamu put on “paid administrative leave” its former chief legal officer Fay Chapman. But Wamu is keeping Chapman on as a consultant. It increased Chapman's pay as of January 1 to $1.1mn, plus she gets a $310,000 bonus.

And Chapman still gets $2.65mn in consulting fees over a two-year period beginning July 1. That maths out to $1,325 per hour. Wamu still pays out this fee to Chapman's husband or heirs if Chapman dies during the two-year term, the deal says.

Next, watch the action in small to mid-size banks heavy into construction lending for things like strip malls and office developments. I previewed this problem for you already in a prior blog (“What the Fed Chairman Really Said”), but there's more.

Sheila Bair, chairman of the Federal Deposit Insurance Corp., reiterated to the Senate Banking committee that construction loans are "one of the chief risks to the banking industry,” notably small and midsize banks, with the percentage of loans that are 90 or more days past due tripling to 3.2% from a year earlier, levels not seen since the early ‘90s. Fox Business's Liz Claman and David Asman reported to you last week that Bair sees an uptick in failures in this banking sector.

The number of banks where construction loans exceed total capital has risen from 1,179 institutions to 2,368 since 2003, according to the FDIC, as I've already noted.

But about 467 publicly traded community and regional banks are overexposed to construction and development loans (C&D), with $204bn in loans exceeding risk-based capital by 185% on average, says Richard Suttmeier, chief market strategist at RightSide.com.

Dallas-based Comerica (CMA) has already put aside $108mn for loan losses in the fourth quarter of 2007, largely due to its sour real estate development loans, notably in California and Michigan.

Marshall & Ilsley Corp. (MI), a Milwaukee-based bank holding company, saw its shares drop after a Goldman Sachs analyst cut his rating on its stock, due to what he said was the company's exposure to construction loans.

RightSide.com's Suttmeier says he's worried about BB&T Bank, a Winston-Salem, NC bank with $128bn in assets that “continues to increase its exposure to C&D loans to $19.5bn from $19.2bn,” Suttmeier says. “BTT has a risk ratio of 182% of risk-based capital.”

Regions Bank, a Birmingham, Ala. bank with $137bn in assets, cut its exposure to C&D loans slightly to $15.5bn from $15.7bn recently, Suttmeier says. Regions has a C&D risk ratio of 122% of risk-based capital, he says.

And always watch the usual suspects in the lending and securitization arena. Citigroup (C), second to Merrill Lynch (MER) in writedown whoppers, has a panoply of credit problems, and now even the head of Dubai Investment Capital says the bank needed more cash if it is to survive.

Even the top-of-the-line outfits are hurting. Thornburg Mortgage (TMA), a jumbo lender that has had a low default rate, is struggling to meet a $270mn margin call from its creditors after asset-backed securities it was using as collateral decreased in value. Analysts have lowered their earnings estimates and ratings agencies warn the lender it is at risk of defaulting on its debts. Shares fell 17.6% to $3.56; they peaked at $28.40 a year ago.

Fremont General just got default notices from two affiliated entities that bought a total of $31.5bn of residential subprime mortgage loans from the company in March 2000, sending shares down 39%.

IndyMac (IMB) is suffering. Aside from its loan servicing and the lender's ‘Financial Freedom' reverse mortgage program, a recent disclosure says “all of our operating segments reported material losses in 2007,” though the company says it expects to rebound in 2008 by, get this, selling loans to Fannie and Freddie, instead of Wall Street.

Yes the implicit backing of the US taxpayer is always preferable to a casino.